Legal Due Diligence 1

Running head: LEGAL DUE DILIGENCE CHECKLIST

Investment Analysis using a Legal Due Diligence Checklist

The Newco Project Company (Newco)

Ryland Hamlet
 Legal Due Diligence 2

10/2/2008 Investment Analysis using a Legal Due Diligence

Checklist

Construction Investment Corporation (CIC) is a venture

capitalist form which invests in growing construction firms. To

avoid the bust and low returns, CIC must perform due diligence

in accessing the viability of providing bridge financing for The

Newco Project Company (Newco), a startup home builder. For

Newco, the current outlook for the industry is excellent. The

problem is there is a high potential for a “dot com” type bust

to occur in the construction industry. Even the professionally

optimistic housing economists employed by the real-estate

industry are now admitting that the good times may be over

(Wallace-Wells, 2004). This paper describes CIC’s investment

criteria, lists the potential issues, develops a checklist,

explains the importance of each checklist item, and describes

how the checklist impacts the Newco bridge financing investment

decision.

CIC Investment Criteria

CIC has requirements for its potential construction

investment targets. The target firm must show current traction

and future sustainability. CIC measures its potential

investments using a simple formula. The investment must yield a

return on equity (ROE) of 15% above the weighted average cost of

capital (WACC) for the industry. According to Damodaran (2003)

of the Stern School of Business, the WACC for homebuilding is

6.83%. The WACC represents the rate that CIC could garner by
 Legal Due Diligence 3

safely lending the same money to an established company in the

homebuilding industry. Any issues which reduce CIC’s ability to

exceed the annual 21.83% should be detected by the checklist.

Potential Issues

There are many situations that can lead to an under

performing investment (1) lack of customer traction (T), (2)

lack of sustainability (S) (Belove, 2002), and (3) legal

entanglements (L). Without traction and sustainability, Newco

may be too risky and take to much time to meet ROE requirements.

Legal issues can be very costly to both traction and

sustainability by tying up resources. Based on a review of

business literature, the following issues are common to

construction firms (Witkowski, 2001; Himelstein, 2003 & Nax,

2003). Potential critical legal issues (L) are in bold.

Potential Issue Category Impact

1. Potential business interruptions L,T,S
2. Inexperienced management team L,T,S
3. Lack of contracts T
4. Bad accounting practices L,S
5. Poor reputation L,T,S
6. Environmental Threats L,T
7. Poor Resources availability T
8. Negative government actions L,T
9. Over-leveraged capital structure S
10. Poor Planning L,S
11. Lack of differentiable product T,S
12. Lack of niche or underserved market S
13. Stagnant or declining market T

Table 1: Potential Issues and Critical Legal Impact

Due Diligence Checklist

CIC evaluates investments using the list of issues and

 Legal Due Diligence 4

potential impacts. CIC develops the checklist by determining

what Newco documentation needs reviewing. The purpose of the

review is to compute the probability and impact of each issue.

The matrix in Appendix B lists each issue category, the issue,

importance, and the relevant item to be checked.

Importance of Each Item

The importance of each item depends on the probability that

the item will occur and the impact. Using the matrix in

Appendix B, each checklist item is reviewed to determine a risk

classification for the issues. The classification is based on

the probability of risk and the potential loss. Figure 1 shows

risk classification based on probability and risk value. This

table is adapted from the risk matrix described by Wallace-Wells

(2004).
 Legal Due Diligence 5

Critical
High
7 8 9

Value (Impact)

Major
Med
4 5 6
Manageable
Low

1 2 3

Remote Possible Likely

Low Med High

Probability

Figure 1: Modified Risk Matrix (Wallace-Wells, 2004)

See Appendix C for a description of the classification numbers

(1-9).

The importance of each issue is based on the risk class number

in Figure 1. The higher the number, the more important is the

risk. The expected value of the loss is computed from the

following formula:

EV = expected value = V1 P1 + V2 P2 + V3 P3 + . . . + Vk Pk,,

where Vk is the loss amount for event k and Pk is the probability

of the event occurring (Davis et al., 2001, p. 326). Table 2

lists the risk importance classification for each issue.

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Potential Issue Category Class P V

1. Potential business interruptions 8 Med High
2. Inexperienced management team 5 Med Med
3. Lack of contracts 7 Low High
4. Bad accounting practices 5 Med Med
5. Poor reputation 8 Med High
6. Environmental Threats 8 Med High
7. Poor Resources availability 9 High High
8. Negative government actions 4 Low Med
9. Over-leveraged capital structure 1 Low Low
10. Poor Planning 8 Med High
11. Lack of differentiable product 6 High Med
12. Lack of niche or underserved market 7 Low High
13. Stagnant or declining market 8 Med High
Table 2: Risk Importance Classification

The red items are critically important items, yellow is less

important, while green indicates issues that are not as

significant.

Potential Impact on the Investment Decision

The impact on the investment decision depends on the net

effect of the expected losses related to issues. For the Newco

project, the expected value of the loss is $20.8 million A

higher expected loss leads smaller or no investment by CIC. The

moderately high risk is supported by the red or critical issues

seen in Table 2. Using a “what-if” scenario, the investment at

which the ROE equals 21.83% is determined. This is the

investment break-even point shown in Table 3. Details are

located in Appendix C.

Projected Cash Flow $ 35,250,200

Risk Adustments $ 20,812,500
Risk Adjusted Cash Flow $ 14,437,700
Investment Break-Even Point $11,286,000
ROE 21.83%
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Table 3: Newco Investment Break-Even Point - 1st Year

Table 3 indicates that CIC can invest up to $11,286,000 and

still meet ROE requirements. Had the break-even been negative,

no investment would be warranted. Additionally, CIC may choose

to invest in other firms that promise a higher yield with less

investment.

Conclusion and Recommendation

Due diligence can often make or break a deal--making the

process of combing through projections, balance sheets and

contracts all the more crucial (Posnock, 2002). The due

diligence allows CIC to objectively determine the projected

value of the investment. CIC reduces risk by investing in

companies like Newco requiring bridge financing. CIC bases all

investment decisions on 1st year figures. Due to the lowered

risk, CIC requires an ROE of only 21.83%. Completing the

checklist, the recommended investment is $11,286,000. The

actual decision is determine by looking beyond the numbers. The

next step is just that, to look beyond the numbers.

 Legal Due Diligence 8

References

Belove, D. (2002, December 5). Liquidity Options: M&A. Retrieved

May 24, 2004, from

www.cob.sjsu.edu/solt_m/files/New%20Venture%20Finance/

Liquidity%20Options%20Belove.ppt

Damodaran, A. (2003, December 24). WACC.XLS. Retrieved May 24,

2004, from www.stern.nyu.edu/~adamodar/pc/datasets/wacc.xls

Davis, D., Utts, J., & Simon, M. K. (2001). Statistics &

research methods for managerial decisions. Pacific Grove,

CA: Brooks Cole.

Himelstein, L. (2003, September 22). Venture capital's dilemma;

scarred by memories of their dot-com losses, cash-rich VCs

remain resolutely reluctant in their avoidance of risky

startups. Business Week Online, , . Retrieved May 24, 2004,

from

http://www.businessweek.com/smallbiz/content/sep2003/sb2003

0919_4952_sb020.htm

Nax, S. (2003, October 5). Low interest rates, strong resale

market contribute to construction boom. The Fresno Bee.

Retrieved May 24, 2004 from

http://web2.infotrac.galegroup.com

Posnock, S. T. (2002, January). Due diligence: The buyer's

perspective; Appraising a potential acquisition involves

more than the scrutiny of balance sheets. Folio: the

Magazine for Magazine Management, 31, SS77-79. Retrieved

May 24, 2004, from University of Phoenix Apollo Library Web

Site: http://web2.infotrac.galegroup.com
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Wallace-Wells, B. (2004, April). There goes the neighborhood.

Washington Monthly, , 1-8.

Witkowski, T. (2001, November 16). Sexy is out: Startups, urged

by nervous VCs, shift gears in push for immediate, viable

products. Boston Business Journal, 21, 1-2. Retrieved May

23, 2004, from University of Phoenix Apollo Library Web

Site: http://web2.infotrac.galegroup.com